Microeconomics Notes on Costs of Production

The Costs of Production

• Production Function

  • Definition: Relationship between quantity of inputs and output.
  • Typically gets flatter as production rises.

• Marginal Product

  • Definition: Increase in output that results from the use of one extra unit of input, holding other inputs constant.
  • Denoted as:
    MPL = \frac{\Delta Q}{\Delta L}

• Costs

  • Total Revenue (TR): Amount received from sales, calculated as TR = P \times Q where P is price and Q is quantity sold.
  • Total Cost (TC): Market value of inputs used, not dependent on output.
  • Profit: Defined as Profit = TR - TC

Importance of Opportunity Costs

• Opportunity Cost: What you forgo to obtain something.
  • Explicit Costs: Input costs that involve cash payments.
  • Implicit Costs: Costs that do not require cash outlay, e.g., opportunity cost of an owner's time.
  • Total Cost Formula: Total Cost = Explicit Costs + Implicit Costs

Types of Profits

• Accounting Profit: Total revenue minus total explicit costs.
• Economic Profit: Total revenue minus total costs (both explicit and implicit).
  • Accounting profit typically exceeds economic profit because the latter accounts for implicit costs.

Short Run vs. Long Run Costs

• Short Run Costs: Some inputs are fixed (e.g., factory size), typically leading to variable costs based on output fluctuation.
• Long Run Costs: All inputs are variable; firms can adjust plant size and scale production to minimize costs.

Economies of Scale**

• Increased production leads to lower per-unit costs due to efficiencies.
• Constant Returns to Scale: Output increases in proportion to input increases.
• Diseconomies of Scale: Expanding production leads to increasing per-unit costs, often due to managerial inefficiencies and coordination issues.

Cost Functions

• Average Total Cost (ATC) and Marginal Cost (MC):
  • Average costs initially decrease as output increases before rising again.
  • Marginal cost increases with output.
  • Marginal Cost Equation: MC = \frac{\Delta TC}{\Delta Q}
  • The MC curve intersects the ATC curve at its minimum point.

Example Analysis - Profit Calculation for Businesses

• Jelani's Gelato Shop Example:
  • Total Revenue Calculation: TR = 5 \times 15000 = 75000
  • Calculate Accounting & Economic Profit:
  • Explicit Costs: Raw Materials + Rent + Interest = 20000 + 12000 + 5000 = 37000
  • Implicit Costs: Opportunity Cost of Labor + Interest Loss = 25000 + 3000 = 28000
  • Accounting Profit: TR - Explicit Costs = 75000 - 37000 = 38000
  • Economic Profit: TR - (Explicit + Implicit Costs) = 75000 - (37000 + 28000) = 10000

Cost Analysis with Different Business Cases

• Angel's Knitting Example:
  • Fixed costs remain constant irrespective of output, while variable costs change with output production. Each type of cost impacts total cost, average cost, and efficiency in production.

Long Run Average Total Cost (LRATC)**

• Firms can choose optimal factory size based on long-term output needs.
  • Different factory sizes (S, M, L) provide different average cost curves.
  • The choice of size impacts efficiency and total cost in the long run, aiming to always operate at the minimum ATC.